Tuesday, April 11, 2006

Math For Real Estate Professionals

What Do Today’s Home Buyers Have in Common With Lotto Players?

Neither are very good at math.



“OK, class! Let’s be seated. We have a lot to cover today.”

“Jenny, could you put the cell phone down?”

“Don! Sit down. No, I don’t care that you have 4 tickets for Van Halen that you want to unload – this is MATH 231 – Math for Real Estate Professionals.”

“Who can tell me what the four basic parts of a monthly house payment are?”

“Anyone? Anyone at all? “

“Jake, can you tell me?”

“PITI. Very good. Now, can you tell me, without looking at Peter’s notes, what PITI stands for?”
“That’s OK. In the interest of time, and the fact I only get paid $45K/year to lecture you dolts, PITI stands for PRINCIPAL, INTEREST, TAXES, INSURANCE.”

“Don, what is PRINCIPAL?”

“No, that’s the guy you had to visit to explain why you were running a sports book in your ethics class.”

“Jenny? Never mind…”

“Yes, Peter?”…”Very good. PRINCIPAL is the amount of the monthly payment devoted to reducing the amount you owe on the house. This is the portion that determines how much the seller receives for his house.”

“Just to make this move along, I’ll explain the rest. INTEREST is the amount that goes to the banker. The higher the rate, the more you pay in INTEREST. TAXES are the amount you pay to keep the state from stealing your house, and INSURANCE is what you pay as homage to our legal system.”

“Given the robust participation in this class, we are going to have one of Dr. E’s pop quizzes.”

“Yeah, I know it sucks, but listen to me. You had better take this seriously. Jenny, let me give you a hint: the answer is not 6%, as you put on all your tests. Jake, do you think you can function without copying off Peter’s paper? And Don, I know you are the one sending threatening phone calls, and the flaming fudge bags, and I don’t care that you have three generations doing time in the joint – you will take the quiz.”

“Yes, Jenny?”… "Because LIFE is a story problem, and you have to know some skill other than how to multiply by .06, yack on your phone, and shop for a new car.”

“Here we go. Assuming you have a home that sells for $600,000 in a hot market, has a 1.25% tax rate, $900 annual homeowner’s insurance, and the buyer uses a 3/1 ARM at 4.75%, and puts 20% down…what is the monthly payment?”

“Jenny?”…”NO! IT IS NOT $36,000, and a write-off on the new Lexus”

“Don?”…”No, we are not calculating how much your cut is before you wrap it and sell it to Fannie.”

“Peter? Please tell me.”…”$3207.06 is the correct answer. Very good.”

“Jake, how did you do?”…”$675,000? WTF? How did you come up with that number?”…”Ahh, I see. We don’t calculate PITI based upon what Don tells us it has to appraise for.”

“Moving right along…Question #2…Assuming everything remains constant, except the new interest rate is 8.75% (where it was in the summer of ’00), calculate PITI.”

“I’ll just do us all a favor and ask Peter.”…”Very good, the answer is $4478.34.”…”That’s an increase of almost 40%, just by moving the interest rate back to where it was before Easy Al started dicking around with the yield curve.”

“Question #3…Assuming the market will not bear the extra $1271/mo, and the buyer can only pay what the current owner pays, how much house does $3207.06 buy you at 8.75%, and taxes remaining at 1.25%, with the same 20% down?”

“Jake, I’ll start with you.”…”How did you get $780,000?”…”No, the market didn’t go up the standard 30%”

“Don, what did you get?”…”NO! THE BUYER PUTS DOWN 20%, AND DOES NOT NEED A PIGGY BACK LOAN AT 103%LTV!!! Put the knife away.”

“Jenny? Dare I ask?”…”$36,000 is STILL not the correct answer.”

“Peter?”…”Correct again. $427,000. The owner just took a $173,000 bath prior to real estate fees.”

“Yes, Jenny, the fees would be $25,620 + $4,270 for a title policy. That is question #4, so you spared us all that higher math.”
“Question #5, how much would our seller have to bring to the closing?”

“$82,890…Very good, Jake. Let me guess, Peter had the same answer.”

“Don, you had a question?”…”Yes, he would likely default, and skip town leaving Fannie with the remainder. Sounds like you know something of this?”

“Our seller would have to bring almost $83 grand to unload his house.”

“Question #6…Assuming the economy tanked with the higher interest rates, and housing was in general decline, so the “hot” investment money came out, while at the same time, buyers were harder to find, and they were a lot more conservative with their money, given all of Greenspan’s inflation, what would be the new value of the home when our prospective buyer pulls 15% of the “hot” money out of his PITI, while pulling another 7%, due to inflation/caution considerations, and interest rates were a flat 9%. Assume the same 20% down (if you could find a buyer with 20% in this environment).”

“Jenny?”…”I know real estate never goes down, but the question is not a BS question. We are dealing in the hypothetical.”…”Sorry, hypothetical means ‘in theory’…What? Sorry, theory means ‘it never happens, but if it did, what would it look like?”…”OK, I KNOW REAL ESTATE NEVER GOES DOWN. Imagine our example is in Dallas. Ahh, much better.”

“NO, JAKE! You just can’t “find the value” and help out the seller.”

“Peter, you are all that stands between me and a padded room with lots of pastels and board games.”…”$324,300.”…PRAISE GOD!, and this is before closing costs and real estate fees…”

“Yes, Jenny, in Dallas they charge 6%. They also eat three times a day, sleep at night, have running water, and call their mothers on Mother’s Day. The difference is they can, in addition to finding their own state on a map, they can find yours.”…”No, Dallas is not in Europe. It is in Texas.”…”You know, TEXAS? Remember Victoria Principal, and Larry Hagman? That’s right. Yes, that is the USA; not the Middle East.”

“Don, what is the total bath our seller takes?”

“No, he just can’t burn the house and collect the insurance money.”

“Jake. What does Peter’s paper say?”…”Yes, in addition to losing his $120,000 down payment, he loses another $178,401.”

“Keep in mind these numbers assume foreclosures, and all the speculative rentals don’t hit the market, to say nothing of all of the Californian’s second homes. If the government raises property taxes, that will make the problem worse, as will the insurance companies if the sellers all were taking advice from Don. If interest rates go above 12%, you can expect the problem to be even worse. Many educated people think there could be a 2/3 to ¾ reduction in the price of homes in the frothy coastal markets.”

“Yes, Jenny, I’m talking about Houston, New Orleans, and Mobile. The Pacific NW will never go down. We are just too special.”

“Well, you kiddies had better run to your marketing class. Next week, we shall discuss INTERNAL RATE OF RETURN FOR A SPECULATIVE RENTAL WITH NEGATIVE CASH FLOW IN A DECLINING MARKET.”

“BTW, Peter. What field do you want to explore when you graduate?”

“Ahh, yes. You are going into Bankruptcy Law. Very prudent.”

“Why did you take this class?”

“Yeah, she probably does give it up on the first date. If not, try 7%”